Grandparents Can Help Save For College Too. But Know These Rules.

On the surface, grandparent-owned 529 Plans work just the same as any other one. You can open any state’s 529 Plan, have tax-free gains when used for qualified higher education expenses, and could be eligible for state tax deductions for your contributions. It’s when we dig a little deeper we see some hidden disadvantages, and advantages, for grandparents. These are things every grandparent should know if they plan on opening a 529 Plan.

Estate Planning

529 Plans can be used as a valuable estate-planning tool by removing large portions from your estate, which would otherwise be exposed to taxes. A grandparent can contribute $14,000 ($28,000 for a couple) per grandchild a year with without effecting their lifetime gifting exemption. Accounts can also be “Superfunded” by contributing 5 years worth of gifts at once. This means a grandparent can contribute $70,000 ($140,000 for a couple) per grandchild at once. With some simple math, we can see that Grandma and Grandpa, whom have 8 grandchildren, can remove $1.12 million from their estate in 1 day through the use of 529 Plans!

Required Minimum Distributions (RMDs)

If you need to start taking RMDs from your retirement account(s) and you have no need for more income, you can always use them to fund 529 Plans for your grandchildren. Johnny may not understand why you got him a 529 Plan instead of that killer new bike right now, but he will in time. The distributions will still be subject to income tax, but remember, as stated above; the money will be removed from your estate.

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Medicaid

Before investing in a 529 Plan, seniors should consider the Medicaid ramifications. As you may or may not know, account owners retain control of funds within a 529 Plan even after the beneficiary turns 18. This retained ownership means that money in a 529 Plan is a countable asset. If something were to happen and you needed nursing home care, all money within a 529 Plan would need to be exhausted before Medicaid would pay the nursing home bills. Exhausting this account means not only liquidating a dedicated college fund, but also subjecting your gains to taxes and a 10% penalty.

A potential solution to this problem is to transfer ownership of the account to the child’s parents, but this is considered a transfer of assets that triggers a Medicaid penalty period. This period is determined by how much you transfer and what Medicaid determines to be the average private pay cost for a nursing home in your state. So, if you transfer a 529 Plan with $50,000 in it, and Medicaid determines the average monthly cost of a nursing home in your state is $5,000, you will be ineligible for 10 months ($50,000/$5,000).

Financial Aid

This is the subject matter I get asked the most about from Grandparents. It is true, a 529 Plan owned by a Grandparent is not reported as an asset under the Free Application for Federal Student Aid (FAFSA). This does NOT mean it has no effect on financial aid for the student. Withdrawals taken and used for the beneficiary’s qualified higher education expenses will be treated as unearned income. Although there is an income protection allowance of $6,260 in 2014-15, any amount in excess of this will reduce the student’s financial aid package by 50% of the distribution amount; nearly 10x harsher treatment than if the parent was the account owner.

There are ways to plan around this however. Obviously, if the family is not planning on applying for financial aid, or is phased out due to their income, this is not a problem. Also, if the account has a value of less than $25,040 (assuming the student has no other income) there shouldn’t be any worries. Just remove an amount each year equal to or less than the income protection allowance and it will be ignored from determining financial aid. The last way is to wait until the final year of college to take a distribution. Since the beneficiary will not need to apply for financial aid the next year, there will be no negative impact.

I’d never tell a grandparent who calls me that saving for their grandchildren’s college is a bad idea. But there are definitely more pieces to consider when making an investment like this if they plan on being the account owner.